Hong Kong As Epicenter Of The Great Power Struggle - China Investment Implications

by: Gene Chan, CFA

China is fighting a multi-front battle. Among the most consequential are trade war with the US, Hong Kong protests, and negative demographic trends.

Hong Kong is a key battleground of our time - protesters are forcing China into a crossroad where any decision will have long-lasting impact on the country's place in history.

While there's a slim chance that China finds its way out of this as a better society, the most likely path will lead to long-term economic destruction.

Investors should sell any trade war resolution induced rally.

My readers know me as a value investor with a business-owner mindset, who prefer to invest based on the underlying fundamentals of individual companies, own them for the long run, and ride out any intermediate macro distractions.

This investing mindset generally works well in a stable market economy built on top of the foundation of a liberal society that emphasizes the freedom and power of the individual, thus unleashing the individual's animal spirit, which is by far the single most important ingredient for durable long term wealth creation.

A liberal society based on rule of law encourages a long term oriented business-owner mindset because we expect, as a self-evident fact (and as history has proven again and again), that tomorrow will be better than today, just like today was better than yesterday, and any macro problems we see today will eventually right itself.

But every once in a while, an emerging market, somewhere along its path of "emerging", takes a wrong turn and permanently damages itself in terms of economic potential. In face of this, even a value investor must confront the mega macro trends that could potentially set back an economy for the remainder of the investor's lifetime.

History is littered with failed experiments in socialism and authoritarianism.

Rising from the collapse of USSR, Russia (RSX) (ERUS) went through a period of reform and rapid growth. But progress has stalled and even moved backwards ever since Vladmir Putin - a "strongman" leader similar to China's Xi Jinping - came into power, and turned Russia's budding democracy and market economy into a farce. Elections were rigged and oppositions were silenced. If you became a billionaire during the reform period in Russia, there's a good likelihood that you were either jailed or had your wealth "nationalized".

Despite starting off as the #2 power during the Cold War, Russia's GDP is still only around 1-2% of the world's GDP today, and it is growing at an anemic 2% without ever becoming a developed country. Russia ultimately failed to diversify its oil-dependent economy and to uplift itself to rich economy status. Putin has probably single-handedly banished Russia to the world's economic backwater for the rest of our lifetimes.

Countless other examples of failed socialist states exist, from Venezuela to Cuba. Perhaps the starkest contrast is the difference in wealth and quality of life between North Korea - a communist dictatorship, and South Korea - a thriving free market democracy.

It is actually quite rare for a developing country to successfully rise to the status of a rich economy, defined as having $25,000 GDP per capita. Post war, we have Japan, Singapore, Taiwan, South Korea, and the re-integrated East Germany. Almost all cases represent societies that moved towards liberal reform in both markets and politics.

But what about socialism with "Chinese characteristics"?

Many would've thought China (FXI) (GXC), the poster child of the emerging market miracle, is an exception to the rule. Although it has yet to reach rich country status, it is indeed an economic titan on its own right.

But make no mistake - the Chinese miracle was a direct aftermath of a series of reforms kicked off by late Deng Xiaoping, which led to arguably the greatest boom in history in terms of the absolute number of people lifted from poverty. Effects of the reforms are still felt to this day, and continue to underpin China's economic growth.

Other Chinese leaders after Deng continued the direction of reform by progressively liberalizing markets, as well as adding safeguards to the governing mechanics of the CPC (Communist Party of China), turning it into a consensus-building political machine with some rudimentary level of checks and balance.

However, Xi Jinping, since coming into power as China's paramount leader, began to dismantle all of that, piece by piece, and at an alarming rate.

On politics, for example, he created an anti-corruption task force to selectively enforce corruption violations as means to silence or eliminate political opponents.

And contrary to CPC traditions, Xi has no clear candidate for succession. Perhaps he doesn't need one anyway, since he eliminated the presidential term limits that was originally established in the 80's during Deng's era.

Kudos to this massive consolidation of power, which could've indeed been a positive thing for China if said power is used to speed up reform and integration into the international system.

But instead, there has been a disturbing trend of anti-market policy actions, and misbehavior on the global stage.

Xi's government reversed course and greatly enhanced the role of SOEs (state-owned enterprises) instead of breaking them up and privatizing them. Even for existing private enterprises, they have to include CPC party members in oversight roles, and this requirement has been extended to include foreign companies operating in China.

Capital control continues to prevent free flow of capital, and despite China's ambition to have its currency compete with the US dollar as the dominant global currency, they continue to maintain tight control on the convertibility of the RMB, and use it as a policy tool to offset impact from tariffs (for instance), thus harming its role as a choice currency for international settlements.

On the advent of the Internet, instead of using it as means to open itself to the world, the CPC saw it as a threat to its power and erected the world's largest firewall, with an ever growing list of banned websites including Facebook (FB), Google (GOOG) (GOOGL) and YouTube. In addition, all mobile games need to go through a central vetting process in China before listing in app stores.

Last year, China began rolling out a Orwellian social credit system, where though various surveillance apparatus, citizens' behavior, online and offline, will be monitored, and a score will be assigned. A bad score will affect a person's permission to go to school, get a job, purchase train tickets or ride an airplane.

All of these policies stifle the individuality and creativity required for high value-add economic growth. They slow or halt exchange of ideas, people, and capital. Even decision-making at the highest level is negatively affected, because being cut-off from the world's media and having a lack of rational discourse on sensitive topics means China's leaders are living in a self-created cocoon, causing them to make major strategic miscalculations.

On international relations, China, instead of using its wealth, culture and ideology to inspire those around it to follow its lead, tends to leverage its position to coerce other countries into doing its bidding.

It uses its military power to essentially take over territorial waters in the South China Sea claimed by other Southeast Asian countries such as Vietnam and Philippines. It uses its market power to bully Hollywood into altering their movie plot lines, and Cathay into ousting the names of its Hong Kong (EWH) employees who exercised their constitutional right to protest.

It is difficult and restrictive for foreigners to access China's domestic market. Foreign companies are often required to form mandatory joint ventures with local firms, make substantial capital investments and technological transfer. Rules are one-sided and enforcement is uneven, making it difficult for many foreign firms such as banks and tech companies to compete with the domestic variants in China. And some, such as Facebook and Google mentioned previously, are blocked from entering the market altogether.

Meanwhile, China has no qualms with taking advantage of the unrestricted free markets of other nations - going on a shopping spree, buying up companies, resources, and real estates with impunity, and (before the trade war) selling its products to the world barrier-free.

All of these activities are coming to a head. China, fighting multiple conflicts internally and externally, now sits at a crossroad. Any decisions made here will have long-lasting impact.

While the momentum from the Deng-era reforms continues to power China's growth, signs have appeared that growth is starting to slow drastically.

The powers-that-be, instead of appreciating the fact that the Chinese miracle is a product of liberalization and international co-operation, chooses to believe a delusion where an authoritarian market economy with "Chinese characteristics" is somehow superior to the model proven to be successful by all developed countries in the world - this arrogance may ultimately prove to be China's gravest mistake.

Alas, this is not a political opinion piece.

All of this background information merely gives context to the investment analysis to follow.

Individually, most of us are powerless to change the course of history, so the best we can do as investors is to observe dispassionately from the sidelines, understand the players involve, anticipate outcomes, and position ourselves to make the best of the situation.

Xi is fighting multiple conflicts at once, and facing tough choices at all fronts. For this article, I will focused on the 3 main drivers that will have the greatest impact on China's future: trade war with the US, Hong Kong protests, and its aging demographics. Note there are many other issues that China is also simultaneously dealing with, namely the South China Sea conflicts, Hong Kong's secondary effects on Taiwan, leverage problem, and malinvestments due to central planning. This article will focus on in my opinion the 3 most consequential battlegrounds.

I will try to be a bit ambitious by covering some really big picture stuff really quickly in a single article. A game theory framework has been applied to forecast China's direction and its investment implications. The flowchart below summarizes the framework in which the intersection of these 3 key drivers can be viewed.

Caution: this work includes a heavy dose of heuristics, guesswork, and probabilities out of my ass. Go ahead and tweak the probability numbers as you see fit, however, I doubt you'll come to a drastically different conclusion under this framework.

A resolution with the USA on trade war is likely.

Rhetorics aside, this should be the first thing we acknowledge. On the surface actions from both sides (and especially from US President Donald Trump) has been erratic to say the least. However, one can always count on the most reliable factor in predicting men's actions - their self-interest. At this juncture, both sides have vested interest in making a deal.

With presidential elections coming up, US President Donald Trump is anxious to get the economy in order.

It is my personal belief that the US and China were actually close to a deal back in May, but Trump felt the timing was not right, so he purposefully scrapped it, or drove a harder line to delay a deal. This is such that when a deal eventually happens, it'll be closer to the time of his reelection campaign.

As the US election heats up, Trump will try his best to "fix" all the problems he caused, if for no reasons other than good optics. For a man who cares deeply about how the stock market is doing, he will likely do everything he can to ensure it rallies into his campaign.

With China, the situation is even more urgent. Its official GDP reports the slowest growth in 27 years. The true situation is probably worse than the curated official number.

Anecdotally, many manufacturers are re-positioning their supply chains, moving production to other low cost jurisdictions such as Vietnam to avoid punitive duties imposed by the US.

With the 70th anniversary of the CPC coming up on October 1st, Xi is under pressure to get as many positive developments under his belt as possible. If China is inclined to make a deal, they will likely try to get it done before the anniversary. However, Trump is probably aware of this, and may try to delay a deal until after their anniversary, or force China to offer more concessions to get it done earlier.

Either way, a deal is likely to be reached before the US election next year. I'm estimating 70:30 odds in favor of a trade deal being reached, as noted in the above flowchart.

In the event that a deal cannot be reached, international companies and capital will continue to exit China. The world will likely decouple into two US-friendly and China-friendly trading blocs.

View this under the lens of China's prevailing demographic headwind - explained in more detail in a later section - China's domestic purchasing power will start to decline in a few years, and with that, the China-friendly side of the economic world will start to whither.

If the trade war persists indefinitely, that alone is enough to end the China economic boom, and we don't have to game the outcome of the Hong Kong protests.

Nonetheless, the more likely outcome is that US and China will reach an agreement one way or another that both sides can accept. When that happens, the stock market rally will be voracious. But it will be short-lived.

Ironically, reaching a deal with the US will give China the impression that it has more time and political capital to clamp down on Hong Kong.

Hong Kong protesters will not go gentle into the night.

Do not go gentle into that good night,

Old age should burn and rave at close of the day;

Rage, rage against the dying of the light.

Though wise men at their end know dark is right,

Because their words had forked no lightning they

Do not go gentle into that good night.

- Dylan Thomas

On the surface, all of this began with a murder in Taiwan, where a Hong Konger killed his pregnant girlfriend and escaped back to Hong Kong. In a stunning display of the Butterfly Effect, this case led to the massive movement for democracy that paralyzed Hong Kong to this day.

Because Hong Kong does not have an extradition law to Greater China (i.e. Mainland China, Macau, and Taiwan), we had no way to charge this murderer. This was a deliberate exclusion in Hong Kong's Basic Law, meant to be a firewall between Hong Kong's world-class legal system based on British common law, and China's opaque legal system.

The murder led to a proposal by Carrie Lam, the Chief Executive of Hong Kong SAR government, to introduce a bill that includes extradition to Greater China. Despite widespread disapproval of this bill, the tone-deaf chief executive attempted to speed up passage of the bill through Hong Kong's LegCo.

It wasn't until a couple of massive protests where over a million people marched in the street, some of whom turned violent, that Lam finally conceded to suspend the bill, declaring verbally that the bill is "dead" (but still haven't officially withdrawn it).

These actions exposed a fundamental flaw in Hong Kong's governance. Lam has taught Hong Kong residents that nothing can alter the government's stance except violence. They've already known there is no true universal suffrage, as the elections for Hong Kong's LegCo and CE are rigged to favor Beijing-backed candidates. Now they also know that peaceful marches are ignored, as Lam did not suspend the bill until the marches turned violent.

Protesters believe that a suspension of the bill without full withdrawal is just a way for the government to buy time until things calm down so they can re-introduce the bill. Thus the movement did not stop- instead it exploded to cover 5 new demands including universal suffrage.

But in fact the root cause has been brewing for years. Any solution to stop the protests without addressing the root cause will be equivalent to treating the symptom without curing the disease.

I believe it is unlikely that the movement will lose steam without getting the underlying issue addressed this time around, given what happened after 2014. Let's take a quick walk down the memory lane.

2014 was the year of the Umbrella Movement in Hong Kong. The central issue at the time was again universal suffrage.

To calm the protesters and to extinguish the movement, Carrie Lam at the time held a "platform of dialog" with the protesters, where she met with the 5 lead protesters to discuss their concerns, and resulting on a promise to reflect their concerns to Beijing and to work on getting Hong Kong towards universal suffrage.

So the protests ended to give Lam's government time to work. There was a period of calm. Since then, these events happened:

  1. 4 out of 5 lead protesters present at the discussion were arrested and jailed
  2. The topic of universal suffrage was never debated or brought up at any official government platform
  3. A British journalist was barred from entering Hong Kong for hosting a debate on independence
  4. Elected lawmakers were expelled from LegCo on technicalities involving oath-taking
  5. Several Hong Kong booksellers were kidnapped and detained by China for selling banned politically sensitive books
  6. A political party - Hong Kong National Party - was banned on national security grounds

This time around, in 2019, Lam is once again promising dialog to quell the protests. This time around, the protesters will not be foolish enough to stop until their demands are fully met.

However, as recent events indicate, China and Hong Kong SAR government's strategy continues to be no concessions, more arrests.

Even though I think the movement will be ultimately futile, I assign low probability that it will peter out on its own. I am estimating 80:20 odds favoring that the protests movement will sustain and continue to escalate, probably to the point of exhaustion of the Hong Kong police force, at which point Beijing will be forced into a tough decision.

To be fair, the Hong Kong police received a lot of bad press, but they are unfortunately stuck between a rock and a hard place. They have mostly followed their employer's (the government's) orders, and have thus far shown incredible restraint, even though at the heat of the moment, a few may have applied force that is considered excessive by onlookers. At times, the police violence seemed purposefully instigated by the protesters to generate press coverage. I consider this an inevitability when you have hundreds of police clashing with thousands of protesters.

The main thing we have to understand is that, in fact, the Hong Kong police is currently the only thing that stands between Hong Kong and China's PLA (People's Liberation Army).

China is fine at the moment with Hong Kongers fighting Hong Kongers. But once the police tires out, switches sides, or simply gives up on maintaining order, China will view that as Hong Kong losing control of the situation. China will be forced into a serious dilemma on taking the matter into its own hands. I believe the protesters will keep escalating until that moment to force the question.

And I think the escalation will ultimately be futile, because Beijing's most likely response will be to forcefully quell the protests with its arm force. In the model, I am estimating that, provided the protests keep escalating (recall 80% chance from above), there is a 70% chance Beijing will crack down on Hong Kong by mobilizing its military.

Consequence will be dire for all parties involved. There will likely be martial law in Hong Kong, with curfews, curbs on Internet and other controls on communication. Existing Hong Kong police force will likely be fired and replaced by mainland police.

At which point, even without an actual massacre, I expect international sanctions on China to happen similar to the Tiananmen Square incident in 1989 - sanctions that set back China's economic development by decades.

But I do hold out some hopes that, when push comes to shove, cooler heads will prevail. I estimate a 30% chance that Beijing will allow concessions to happen for Hong Kong - perhaps even letting Hong Kong finally implement universal suffrage.

However, Beijing's dilemma is that by allowing concessions, not only will Xi Jinping appear soft to his party members, it has potential to cause copy-cat movements in other areas of China.

Macau recently held an unofficial vote on universal suffrage, even though its organizers faced threats and attacks. Other oppressed regions in China, such as Xinjiang and Tibet, may have similar thoughts.

If China does choose to take the high road and use this opportunity to implement widespread democratic reform, it would be a hugely positive development for China in the long term, as well as humankind as a whole. But that won't happen without significant unrest and chaos first in the medium term.

If the Hong Kong protest movement somehow loses momentum on its own (20% chance in the model), Beijing's most likely response will be to tighten control on Hong Kong, eliminating various freedoms it currently enjoys, and speed up its integration with Mainland China. I handicap 90% chance for this response.

Again, there is a slight chance that China will take the high road. As the protests lose momentum, there is a small chance that China will learn the lesson and implement widespread reforms to prevent future unrests in Hong Kong and elsewhere. Out of the 20% chance of the protests losing momentum, I estimate a 10% chance for China to take it as a lesson learned. In fact, as depicted in the flowchart above, this extremely unlikely path is the only path that is positive for China in both medium term and long term.

One can surely hope.

Without significant reform, China will get old before it gets rich.

All of the recent events need to be viewed within the larger context of negative demographics trends in China.

As a direct consequence of China's one-child policy implemented several decades ago, there are not enough young people replacing old people in China, and its population at a whole is rapidly aging. Despite the policy's recent abolishment and change to a two-child policy, it is too little too late (when will they learn that central planning doesn't work?). We are already at the point where more Chinese people are exiting the working age than entering it.

The following two charts from ZeroHedge compares China's demographics with Japan's a generation ago and America's today:

Source: ZeroHedge

Source: ZeroHedge

This is an inevitability which the Chinese government has no control over, and it is the only major driver not represented by a decision point in my model. It is the prevailing wind that underlies all of the possible outcomes.

Compounding this matter further, China has pathetic immigration rate. Note most of the rich world also has demographic issues with respect to their birth rates, but the issues are mostly offset by a steady influx of migrants from other countries volunteering to join them. The US, for example, admits over 1 million immigrants every single year.

China does not have this luxury. Despite having a larger population base, modern China has about 1 million immigrants in all of its history, including people who came from Hong Kong and Macau. Its annual immigration rate is infinitesimally small to non-existent. Those who do come are usually from other oppressed countries such as North Korea.

And this brings us to the crux of the issue, and why China needs reform:

Almost no one outside of China aspires to be a part of China.

This contrasts with the US, where they have trouble handling the influx of illegal immigrants who are literally dying to get there.

This fundamental difference between aspiration vs coercion is lost in a nation that only understands influence via money or by force. China's strategy sows resentment rather than admiration.

And it also explains why China gives too much credit to the West for "orchestrating" the protests in Hong Kong.

Sure, there were meetings between Hong Kong protesters and various non-profits and government organizations in the West. There are organizations that routinely meet with opposition leaders in various countries. Sure, there may be small amount of funding to support the protests provided by various charities around the world.

But these activities are merely the grease that smooths the turning of the wheel - not to be mistaken as the cause of why the wheel is turning in the first place.

First and foremost, the free world led by America is held together by an idea - the idea of freedom, individual liberty, and fundamental human rights - and it is a highly contagious idea. Having tasted freedom, very few willingly give it up.

Hong Kong is a crucial chess piece in the great power struggle between the world's two superpowers with opposing ideologies.

There is a groundswell yearning of freedom in Hong Kong. The West may have "influenced" Hong Kong by introducing them to the idea. Chinese leadership may have confused this inspirational influence with some kind of sinister foreign mastermind who's centrally planning the protests - the only kind of influence they understand. The nuance is complete lost on them. China cannot fathom a leaderless movement held together by nothing but the idea of freedom.

In order for China to offset the negative economic effects from its rapidly aging population, it needs to attract immigrants, capital and know-how. It needs to stimulate debate and creativity in order to move its economy further up the value chain.

Without reform, China's aging demographics will cause the country's productive capacity and economy to decline. When that happens, we will finally see how happy the world really is on dealing with a China that has no money.

In a nation where order is maintained via coercion and subversion rather than appealing to the people's hearts and minds, achieving developed status requires a heavy dose of reform, and a massive change in its leadership's perspective. True soft power comes from the ability to inspire people to willingly become a part of your society and follow your leadership.

Against the prevailing demographic headwind, both market and political reforms are necessary conditions for China to continue to thrive, and for the Chinese miracle to endure.

And I have, in my model, estimated how likely it is for this to happen.

What does this all mean to our investment strategy?

Recall earlier I explained why a trade deal between China and the US is likely to happen. Post-trade war, the event that has the biggest impact on China's future will be the trajectory of the Hong Kong protest, and China's handling of it. All of this should be viewed within the context of an aging demographics.

In the flowchart above, I modeled the interaction between these 3 factors with compounded probabilities to come up with final probabilities of the 4 possible outcomes. I will summarize again here.

69% chance that either the trade war fails to resolve or China commences military crack-down on Hong Kong, both leading to negative consequences for the Chinese economy in medium and long term.

17% chance that trade war resolves, but Hong Kong protests escalate, China agrees to meet the demands of Hong Kong protesters, causing copy-cat movements in other regions of China. This is negative for China in the medium term as unrest spreads, but potentially positive in the long term if it leads to serious reform.

13% chance that trade war resolves, Hong Kong protests lose steam and subside, and during period of calm, China chooses to tighten control on Hong Kong and speed up its integration into mainland. This is positive in the medium term as we have a illusion of stability, but negative long term as the effect of a rapidly aging demographics is not offset by deep reform.

1% chance that the trade war resolves, Hong Kong protests lose steam and subside, and during period of calm, China learns a lesson, implements widespread reform to prevent future unrest in Hong Kong and elsewhere. This is positive in both medium and long term, as China resumes its path towards a open society and attempts to achieve it in a stable and gradual manner.

Based on the probabilities above, Investors may want to sell Chinese or Hong Kong-related stocks and funds on any rally induced by a trade war resolution with the US.


China is sitting at a critical intersection, where multiple events are forcing it to face uncomfortable choices at multiple fronts.

There is a way for China to come out of this unscathed, but it will involve choices that are unlikely to be made in the current political climate.

Therefore, investors may want to sell Chinese and Hong Kong shares, or companies and funds heavily exposed to China and Hong Kong on any stock market rally induced by a trade war resolution with the US.

We must remain pragmatic as investors. While I root for the country of my ethnic origin to come out of this a better society, as an investor, this is not a high probability outcome that I can bank on.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.